Insight

US-China relations sour amid COVID-19’s spread

Relations between the two countries may be going through a rough patch and stoking market volatility, but David Chao sees some positive outcomes for markets.

As the number of COVID-19 infections continue to rise globally, so have US-China tensions. With the US presidential election looming in November this year, relations could fray further as presidential contenders are likely to want to appear tough on China. Already, President Trump’s tone has shifted from his earlier message of completing the Phase 1 trade deal with China, to a strident one where he blames China for the economic impact from COVID-19. 

There have been three critical developments as of late in US-China relations. Firstly, there have been new US regulation on export controls to Chinese technology company Huawei. The heightened restrictions prevent semiconductor companies and perhaps even memory chip players from supplying chips to Huawei. This not only creates uncertainty for Huawei’s future, but puts a significant damper on China’s big push for new infrastructure and its 5G national rollout later this year. In fact, I see that the whole Asian region will be affected, as many industries and sectors were set to benefit from this new wave of capex spend and product upcycle.

Even though there is still a grace period of 120 days before the US Commerce Department’s rule takes effect, however it looks likely that companies will have to apply for a license from the department to sell chips to Huawei. What bears watching is any meaningful shifts in the technology supply chain as Huawei continues to be one of the biggest players in the industry.  

Secondly, there has been a push among US policymakers to delist Chinese companies from the US markets. They current list on those boards through ADRs (American Depositary Receipts). On May 20, the US Senate unanimously passed a bill that would force foreign-based companies listed on US exchanges to submit to oversight by the US Public Company Accounting Oversight Board (PCAOB). Companies will also have to certify that they are not owned or controlled for a foreign government. The bill is currently before the House and will most likely pass shortly.

Beijing has its own law prohibiting Chinese companies from disclosing their audited financials to foreign governments. Should the US bill become signed into law, we may start to see many Chinese companies move to stock exchanges that don’t require them to change their reporting standards, such as Hong Kong or London.

Finally, China’s National People’s Congress recently proposed a national security law for Hong Kong. In response, the US State Department recently certified in its annual review of Hong Kong’s status that the territory was no longer politically autonomous from China. US-China relations took another nosedive recently when President Trump declared that his administration would “begin the process” of ending the US’ special trading and law enforcement relationship with Hong Kong, although his remarks left out important details, such as the exact scope of the actions and the timeframe.    

The White House will now begin a review process to assess what kind of actions to take next – although I think it’s highly unlikely that Washington will take any action that will affect Hong Kong’s financial status as a USD funding center. Both the US and China benefit from Hong Kong being a transparent and open jurisdiction to do business. There are around 1,200 US companies in Hong Kong, of which 800 are either regional offices or regional headquarters.1 According to the US Census Bureau, the US enjoys a meaningful trade surplus of US$31bn in 2018 with Hong Kong. It is very likely that cooler heads will ultimately prevail in Washington, and that the administration will be restrained against any action that could seriously harm US businesses and interests in Hong Kong.   

Investment implications for Asian equities and Hong Kong’s stock market

I see a few positive outcomes. It appears that the Phase 1 Deal continues to be on the table, although China may ask for a purchase-agreement extension due to the COVID-19. I think we may also see some high-level purchases from China of agriculture products in key US presidential battleground states that President Trump would find useful. For the time being, I think it’s highly unlikely that we will see a snapback in tariffs.    

In addition, northern Asia has done a good job with flattening the new infections curve and already we’re seeing economic activity rebound, albeit tentatively and measuredly. I expect that there are only a few economies in the world that will see positive economic growth this year –China, South Korea, Taiwan and Vietnam being among those. I continue to be optimistic about Chinese onshore equities and EM Asia risk assets including equities and credit, as these economies are the first to exit the economic lockdowns, and are likely to chalk up growth in the 2H of 2020.

What I’ll be looking out for is whether US-China relations deteriorate, as it may threaten this nascent growth across the region. It’s feasible that increasing geopolitical friction between the world’s two largest economies may send investors fleeing for safe-haven assets.

Currently, I think that EM Asia equity valuations are compelling especially when compared to DM equities such as the US S&P, which currently trades at a premium to its historical multiple.

While Hong Kong stocks are undervalued on a price/book value basis, I continue to expect near-term market volatility due to souring US-China relations and as market participants wait for the final details of the national security bill and retaliatory actions from the US. For longer term investors, I think that it makes sense to start building positions at these levels. I think that the Hong Kong stock exchange’s future remains bright, driven by Chinese companies continuing to list on the city’s exchange and raise capital offshore. In fact, Hong Kong risk assets could benefit in the longer term from the national security law, as mainland investors view Hong Kong with diminished political and protest risks. It’s important to remember that around 75% of the exchange’s market capitalization is made up of mainland companies that have little to no exposure to Hong Kong’s economy. Due to the Stock Connect program that allows institutional investors from the mainland and Hong Kong to invest in each other’s stock market, southbound flows have been strong recently, with Mainland investors snapping up undervalued Chinese companies.

In addition, a large number of Chinese digital-economy companies are planning to return to the exchange for listings in the future. This is likely to change the Hang Seng Index’s composition, which is currently dominated by financials and real estate companies, making it more attractive to investors. As such, NASDAQ’s recent policies to tighten the listing requirement of foreign firms as well as the US government’s recent actions threatening to delist Chinese firms from US exchanges will likely benefit Hong Kong’s stock exchange. The risk from delisting Chinese companies in the US will accelerate the trend of them (the Chinese ADRs are currently valued at around US$1.7 trillion2) returning to list in Hong Kong and Hong Kong’s developed capital markets will be an increasingly important place for Chinese companies to access and to mobilize overseas capital. Therefore, I don’t think that Beijing’s new national security law will change this long-term trajectory.

David Chao is Global Market Strategist for Asia Pacific.

^1 Source: American Chamber of Commerce in Hong Kong, as of May 28, 2020.
^2 Source: Bloomberg, as of May 28, 2020.